We contribute to the intersection of top executive turnover and compensation research by investigating pay structure implications on turnover, focusing on the second best-paid executive as the one being closest to winning the tournament for the best-paid position. Building on tournament theory and using competing-risks survival regression, we develop and test hypotheses with regard to the effects of pay disparity among a firm’s top executives and external pay alternatives on the exit of the second best-paid executive. For a sample of S&P 500 firms in the 14-year period between 1993 and 2006, we find that comparisons with higher paid executives and external pay alternatives matter for individuals’ decisions whether to stay in or to leave a pay tournament, whereas comparisons to lower paid executives do not.

Press Release 13 March 2014

Executive Pay Matters

The Other CEO Pay Ratio and Its Influence on Succession Planning [13 March 2014]

In the wake of the Securities and Exchange Commission’s proposed rules requiring disclosure of the ratio of CEO pay to that of the median employee, some observers have expressed interest in a different ratio: the one between the CEO’s pay and that of the second highest-paid employee. Their interest stems from a valid concern — the desire that companies have thoughtful succession plans in place. The theory is that a good succession plan means paying the likely successor more closely to the CEO to discourage the heir apparent from leaving for greener pastures.

However, a recent study on the pay differences between the two highest-paid executives calls this logic into question. Conducted by Stephanie Mankel of the EBS Business School in Wiesbaden, Ansgar Richter of the University of Liverpool Management School and Nikolous Uhlenbruck of the University of Montana, the study found that it’s the expectation of receiving much higher pay upon being promoted to CEO that keeps successors in place, as predicted by advocates of “tournament theory.” Consistent with that theory, the study also found that current pay levels play only a marginal role in retaining the number-two executive and that the pay difference between the CEO and the next best paid is irrelevant to whether the latter stays on board.

The authors theorize that because CEO paydays are so lucrative, executives are willing to stay in the tournament to get the job, regardless of their current pay level. A similar tournament mindset has been observed in professional services firms, where the lure of becoming a partner outweighs the long hours and low pay for those trying to get there.

The study also found that the older the CEO, the lower the turnover rate for the next best paid, reinforcing the notion that an imminent payoff makes sticking around even more palatable — and looking at the potential payoff shows why. Market data confirm that a pay increase can be significant, with internal promotions in the S&P 500 getting on average a $1.9 million pay bump when becoming CEO.

The study does not suggest that consideration of peer pay data is unimportant in setting the pay of senior executives. Clearly, each circumstance is different and companies should not leave it to chance that they are paying their executives enough to keep them from taking the job across the street. Rather, the study suggests that tying the next best-paid executive’s pay to that of the CEO is an unwise use of company resources because it doesn’t help with retention. And disclosure of this information is not a substitute for an effective succession plan.

The study’s findings are at odds with the conventional wisdom that pay discrepancies between the CEO and other executives provide a window into good corporate governance. Theory being theory, there are a number of assumptions built into the notion of what constitutes sound succession planning, with the most prevalent being that internal candidates should always be favored to succeed the CEO. A key argument for this viewpoint is the assumption that hiring external successors is more expensive than promoting from within, which is actually supported by the data. Studies have found that external hires receive pay premiums of 30% or more compared with internal CEO promotions.

Another common assumption is that internal CEO successors tend to be more successful because they understand the organization and are more likely to provide a steady hand when they step in. However, this notion is not supported by at least one study by Ayse Karaevli of the Sabanci University School of Management in Istanbul and Edward J. Zajac at Northwestern’s Kellogg School of Management. That study found that it’s hard to generalize about success rates given the differences in circumstances under which a new CEO comes on board.

For example, the study’s authors found that external CEO hires can be more successful when faced with poor company performance and/or high industry growth. External hires may also be more successful when they replace the company’s senior management team with new executives. But, they may not be as successful as CEOs promoted from within when they rush to make strategic changes in the early post-succession period. This study reflects the notion that the benefits of hiring from within are company-specific, and the issue does not lend itself to simple generalizations.

Perhaps the lesson from these studies is that companies should do a better job of helping shareholders understand that they have in place a sound process for CEO succession planning. Some companies may take a tournament approach and choose a successor from a range of candidates, while others may be grooming a particular executive. And others — due to unique business or talent issues — may need to look outside the company. Shareholders deserve to know that management and the board are thinking about the issue, and companies should disclose that they are doing so in their proxies. How far the disclosure should go will be a nuanced exercise that will differ from company to company.

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